Earlier, we posted about whether holders of Venezuelan bonds would be better off accelerating and obtaining judgments sooner rather than later. In a nutshell, here was the point:

When a restructuring comes (and it will), the two primary weapons the restructurer is likely to use are CACs and Exit Consents. A bondholder who obtains a money judgment, as best we can tell, escapes the threat of either CACs or Exit Consents being used against her.

We heard from a number of people with questions prompted by the post. Here are some of them, and our conjectures as to answers.

Is there really no precedent for using contract terms to “unwind” a judgment?

We don’t know of any. As mentioned in our earlier post, it is clear that some contract rights survive the judgment. This includes the pari passu clause, according to Judge Griesa’s opinion in the NML litigation, which allowed bondholders with money judgments to assert a new claim for injunctive relief under that clause.

On the other hand, the pari passu clause isn’t a great analogy here. Among other reasons, it was used in the NML litigation to give a new remedy to creditors who already held money judgments. What we’re looking for is a case where other parties (either the judgment debtor or other creditors) used contract rights to negate or modify a judgment obtained through litigation. We know of no authority examining the use of CACs or Exit Consents, so we looked a bit farther afield. What about acceleration rights?

Bonds issued under a trust indenture, like PDVSA’s bonds, typically allow a creditor minority (usually 25%) to instruct the trustee to accelerate. After acceleration, the trustee usually conducts the litigation, but there are some situations in which individual bondholders can sue. Importantly, a typical indenture also allows a creditor majority to rescind a declaration of acceleration. What if such a rescission happens after one or more individual bondholders have obtained money judgments?

For readers interested in this topic generally, we’d recommend a September 2016 article in Butterworths Journal of International Banking and Financial Law called “Trust Indentures and Sovereign Bonds: Who Can Sue,” by Lee Buchheit and Sofia Martos, both experts in the field. The article also includes this fascinating quote from the commentary to the American Bar Foundation’s model indenture provisions:

By the terms of the indenture, an acceleration of maturity can always be annulled by the holders of a majority in amount of the debentures. The procuring of a judgment by a few debentureholders on the basis of the accelerated maturity and a subsequent rescission of acceleration would present a most difficult problem whose solution is not to be found in any decided case.

A most difficult problem indeed! It apparently wasn’t clear to the drafters of the ABF model indenture provisions whether a creditor majority could de-accelerate a bondholder’s claim after it has been reduced to judgment, and we haven’t found anything since to clarify the question. But perhaps some of our readers know of something we have missed? (For readers with access to the ABF Commentaries, the quote is on pp. 234-35).

What about my interest rate? What am I earning on unpaid interest and principal if I get a judgment?

This is what investors seem to really care about – and perhaps for good reason, because interest rates differ as a function of whether one obtains a judgment. These differences may explain why investors would prefer to defer litigation. With the important caveat that we are not experts on these questions, our sense is that, after an investor reduces her claim to a judgment, that claim will accrue interest at an unattractive rate.

More particularly, if the bond says (and most do) that interest will accrue at the contractual rate "until the principal is paid in full," then:

Interest continues to accrue on principal post-maturity/acceleration at the contract rate, and

Interest will accrue on unpaid amounts of interest post-maturity/acceleration at the 9 percent NY statutory rate (until judgment). Once a judgment is handed down, the judgment will bear interest at the federal statutory rate (which is more like 3 percent -- it floats based on US Treasury rates).

The differences between contract and statutory interest can be dramatic, especially post-judgment. That can provide some incentive to delay litigation, although delay can also backfire.

There were echoes of this tension after Argentina’s default. Those who followed that crisis may recall significant differences in the strategies holdout creditors pursued. For example, Dart got judgments early, thereby protecting itself from Argentina’s possible use of Exit Consents. NML, by contrast, waited somewhat longer, often to spectacular effect. Some readers may recall the infamous FRANs, which yielded spectacular returns to NML. (The FRANSs are described by Matt Levine of Bloomberg here; also note the fun graph depicting the significance of computing interest at the contract rather than the statutory rate).

Ultimately, waiting proved advantageous for NML, although it might have regretted its decision if Argentina had used Exit Consents to modify the bond contracts before judgment. But then, perhaps the fact that Dart had already obtained money judgments discouraged the use of Exit Consents…?

At this stage, it is hard for us to see Venezuela abjuring the use Exit Consents. That said, if enough holders get judgments, the value of using Exit Consents diminishes. And if the end result is that Exit Consents are not used, then the ones to gain the most will be those who waited longest.

It is both. Indeed, if the bill were stripped of its title IV, I think most people could live with it. But title IV is a doozy.

Most notably, it raises the threshold for additional regulation under Dodd-Frank from $50 billion in assets to $250 billion. Banks with more than $50 billion in assets are not community banks.

The banks in the zone of deregulation include State Street, SunTrust, Fifth Third, Citizens, and other banks of this ilk. In short, with the possible exception of State Street, this is not a deregulatory gift to "Wall Street," but rather to the next rung of banks, all of which experienced extreme troubles in 2008-2009, and all of which participated in TARP.

My prime concern – given my area of study – is that these banks will no longer be required to prepare "living wills." That is, they will not have to work with regulators on resolution plans.

Coverage of Federal Reserve Chairman Jerome Powell's Congressional testimony highlighted his optimism about economic growth and its implications for future interest rate hikes. Less widely covered were his brief remarks on the student loan debt crisis. Citing the macroeconomic drag of a trillion-and-a-half dollar student loan debt, chairman Powell testified that he "would be at a loss to explain" why student loans cannot be discharged in bankruptcy. According to Fed research, Powell noted, nondischargeable student loan debt has long-term negative effects on the path of borrowers' economic life.

There's been a lot of poorly informed reporting about the Stormy Daniels contract litigation, including in some quite reputable publications, but by reporters who just aren't well versed in legal issues. For example, I've seen repeated reference to an "arbitration judge" (no such creature exists!) or to a "restraining order" (there's no enforceable order around as far as I can tell. So what I'm going to do in this blog post, as a public service and by virtue of some tangential connection to our blog's focus, dealing with arbitration agreement (to satisfy Sergeant-at-Blog Lawless), I want to clarify some things about the Stormy Daniels contract litigation and engage in a wee bit of informed speculation based on tantalizing clues in the contract. As a preliminary matter, though, I apologize for the clickbait title.

Let's start with the facts as we know them.

(1) There is a purported contract among three parties: Peggy Peterson, David Dennison, and Essential Consultants, LLC (EC). The contract says that these aren't the parties' real names, but that their real names are revealed in a side agreement.

(2) Peggy Peterson is really Stormy Daniels (the nom-de-porn of Stephanie Clifford). EC is a shell company created by Michael Cohen, Donald Trump's lawyer and fixer. And David Dennison is allegedly Donald J. Trump.

(3) The contract says is a settlement agreement in which Peterson (PP) and Dennison (DD) engage in a mutual release of litigation claims and Essential Consultants kicks in $130k to Peterson. In other words, PP is supposed to give DD a litigation release in exchange for a litigation release from DD and $130k from Essential Consultants.

(4) The contract provides that disputes between PP and DD are to be resolved in confidential arbitration.

(5) The contract provides that DD may obtain a preliminary restraining order against PP to prevent her from breaching her obligations of confidentiality under the releases.

(6) The contract provides for DD having the option of either actual damages or stipulated damages of $1 million if PP breaches.

(7) The only public copy of the contract is signed by PP and EC, but not by DD. The signatures are notarized, indicating the date on which they were signed.

(8) Stormy Daniels was paid $130K by EC. The ultimate source of the funds for EC LLC remains unclear.

(9) EC commenced an ex parte arbitration action to obtain a preliminary restraining order against PP. An arbitrator granted the request, but there does not appear to be any court order confirming the award.

(10) Stormy Daniels brought suit in California state court seeking a declaratory judgment that the contract was void as unconscionable/against public policy and unenforceable because it lacks a signature from David Dennison.

So what are we to make of this mess?

First, it's important to note that this is not the classic bilateral contract situation: there are three, not two contractual parties. The contract does refer to Dennison and Essential Consultants "on the one part" and Peterson "on the other," but Dennison and Essential are very clearly not the same party, and the contract does not specify anything about their relationship.

Second, the choice of names here is amusing, but I don't think it's coincidental. Why on earth would someone use the names Peggy Peterson and David Dennison? I think it is law-school-note shorthand for Plaintiff (PP) and Defendant (DD). If I'm right, I'm guessing that this is not the only contract that Michael Cohen (the principal of Essential Consultants and Donald Trump's lawyer) has written with Peggy and Dennison. Indeed I'd wager that Stormy Daniels isn't the only "Peggy Peterson" out there, particularly as some the terms of this contract don't seem to have any relation to the claims (as far as we know them) that Stormy Daniels might have about Trump, such as claims about "unacknowledged children". There's a tantalizing hint here that there might be another Trump settlement agreement regarding paternity claims.

Is the contract enforceable?

Certain contracts are subject to states' Statutes of Frauds, which are requirements that there be a writing that indicates a contract that is signed by the parties. I'm pretty sure the Statute of Frauds applies here both because of the dollar amount of the contract and because it cannot be performed in a year as it involves a permanent obligation of confidentiality. There's no statutory exception for partial performance, but in at least some other contexts California courts have found a partial performance exception to the statute of frauds. So maybe Stormy can't win on a Statute of Frauds argument, but she can still argue that there was no agreement ever formed because of the lack of a signature by DD.

It's axiomatic that parties have to assent to a contract. The signature goes to the question of whether there is any indication of assent to the contract by DD. One way to express assent would be a signature, but it's absence is not inherently fatal. Another way of showing assent would be performance. Has DD taken any actions that indicate performance? It's not clear. There's no way to tell if litigation claims have been released by DD because all that means is that DD wouldn't bring litigation--but that's also consistent with retaining the claims and choosing not to act on them. But DD might have taken receipt of pictures, text messages, etc. under the contract. The acceptance of a benefit might be enough to indicate acceptance. And then there are estoppel type arguments that DD/EC could raise against PP. The facts aren't clear, but I think Stormy has at least a plausible case that there is no enforceable contract with DD. (This assumes that there isn't another copy of the contract signed by DD, but if so, there's a question of when it was signed...)

What about the argument that Michael Cohen was Trump's agent and was signing for him. Cohen could have signed for Trump as his agent, but there's no indication that he did. The signature is for EC LLC, not for DD. Cohen can sign in multiple capacities, of course, but he didn't. EC LLC could be signing for Trump, but if so it creates a serious campaign finance law violation problem as it would mean that the $130K payment was a payment on behalf of Trump (which of course it was). Given the political benefit to Trump of keeping Stormy quiet (and the timing of the agreement, on the eve of the election), this would readily be seen as a campaign contribution, and if so it would have been above legal contribution limits (violation by Cohen), and it would be undisclosed, another violation (by Trump). EC LLC/DD are kind of precluded from raising this argument, then, without creating more problems for themselves with the campaign finance laws.

Note, btw, that even if there's no contract, it doesn't mean that Stormy gets to keep the $130k. She should be returning the $130K and EC/DD would return any items they took from her.

There's also Stormy's void-as-against-public policy argument. I'm not going to opine on that--everything gets weird when dealing with the public's interest in the Presidency.

What about the arbitration proceeding?

EC LLC brought an arbitration proceeding against PP to get a preliminary restraining order. As a starting matter, let's be clear about terminology. Arbitration is before an arbitrator, not a judge. That's just a private party delegated to resolve a dispute. Even if the arbitrator happens to be a retired judge (as was the case here), it's still an arbitrator, not a judge. And that means that the arbitrator has no power herself to enforce any arbitration award. If you win an arbitration award, you still have to go to court to get the court to enforce the order, and that creates an opportunity for the losing party in the arbitration to challenge the award. The grounds for challenging arbitration awards are pretty limited and narrow--a simple mistake of law or fact by the arbitrator isn't going to do it--but if the arbitrator lacked authority to arbitrate in the first place, it's a different matter.

As far as I can tell, there has been no attempt to enforce the arbitration award of the preliminary restraining order. In other words, EC (Michael Cohen) got an ex parte award from an arbitrator, but no court order to enforce it. My search for dockets on Bloomberg Law involving "Peggy Peterson" or "EC LLC" didn't turn up any actions to enforce the award. And frankly, I'm not surprised. I don't think this award is enforceable because the arbitrator had no authority to even hear the matter, much less grant the relief she granted. The arbitration provision governs only disputes between PP and DD, not disputes involving EC, and the preliminary relief provision is only for DD, not for EC. EC has as much standing to seek preliminary injunctive relief via arbitration as Sasquatch.

Wait, you might say, isn't EC LLC a third-party beneficiary of the arbitration rights? Nuh-uh. EC is a named party to the contract, so it gets the benefits spelled out in the contract and nothing more; a third-party beneficiary is, by definition, not a party to the contract.

Ok, but isn't EC LLC really just the same thing as David Dennison/Donald J. Trump? Isn't it an agent/alter ego/creature of Trump? Well, yeah, of course it is, but just as above, Michael Cohen/EC LLC can't run with that argument because it sets up some pretty serious campaign finance law violations, the sort of thing that cost John Edwards his law license and which carry real criminal penalties.

In other words, what's happened is that Michael Cohen made some threats but hasn't attempted to follow through by seeking to confirm the arbitrator's award, probably because it's not likely to be confirmable and also because it isn't likely to do any good at this point.

fwiw, if Stormy wants to challenge the arbitration clause, she needs to do so specifically, rather than challenging the entire contract or else the contract should go to the arbitrator to decide on enforceability, although, as Mark Weidemaier notes, the contract lacks a provision specifying that the arbitrator makes that decision. I believe that even in its absence under Buckeye Check Cashingthat the arbitrator still makes that decision, but it's possible that Buckeye Check Cashing assumed the existence of such a delegation clause.

What comes next?

So where we're left is the question of whether Donald Trump et al. will even respond to Stormy Daniels complaint in her lawsuit or will take a default judgment. My money is on the default judgment. Trump's likely to lose if he litigates, and doesn't really have any upside to winning. He can't put the genie back in the bottle at this point. (What more does she have to reveal? She's already said that they had boring sex one time, that's it. Some have speculated, based on the agreement, that there are pictures, but I think that's just boilerplate or holdovers from other Trump settlements. If Stormy had nude pictures of Trump, she'd have been paid a helluva lot more than $130k for them.) The more he fights, the more attention Stormy gets. I'm not sure what Trump's end-game is here, but at this point it seems that trying to enforce the contract is kind of beside the point. Stormy's going to tell her tale, and Trump's best move is to hope that we're all so inured to scandal that it's a yawn.

For readers who haven't been following along: Stephanie Clifford, aka Stormy Daniels, is an adult film star who allegedly had a sexual relationship with Donald Trump in the mid-2000s. She recently sued Trump and other defendants, seeking to invalidate a settlement agreement in which she was paid to keep silent about the details of the alleged relationship. Here is her complaint, which includes the settlement agreement as an exhibit. And here is some coverage of background details.

The settlement agreement includes an arbitration clause, which should prompt some reflection about the use of arbitration to silence victims of sexual assault (a topic that has attracted attention in the wake of revelations about Harvey Weinstein). On the other hand, people are often too quick to blame arbitration for unrelated problems, so I hope this (long-ish) post can offer a bit of clarity. The short version: Whoever drafted the agreement between Stormy Daniels and "David Dennison" gets an A for cynicism, but would have to beg for a C in my arbitration class. (I’m guessing the draftsperson would fail professional responsibility...)

First, some factual background:

The settlement agreement uses pseudonyms, Peggy Peterson and David Dennison. In exchange for a payment of $130,000, “Peterson” agrees among other things not to disclose confidential information about Dennison, their “alleged sexual conduct,” and other matters. She also agrees to arbitrate “any and all claims or controversies” arising between her and Dennison. The agreement designates two potential institutions to administer the arbitration: JAMS and Action Dispute Resolution Services.

Peterson (i.e., Daniels) signed the contract (through her lawyer), but Dennison did not. Instead, the contract was signed by Michael Cohen (a lawyer for Trump), on behalf of an entity named Essential Consultants, which allegedly was formed to hide the source of the hush money. There is a blank for Dennison’s signature, but it is empty.

The settlement agreement requires all parties to keep the alleged relationship confidential. Formally, this has nothing to do with the arbitration agreement. Parties to an arbitration agreement do not have confidentiality obligations (unlike the arbitrator and any administering institution, which do). The arbitration hearing will be private; unlike a court hearing, members of the public cannot attend. But the parties can tell whatever they want to whomever they want, unless they have separately agreed to maintain confidentiality. Thus, Daniels’s confidentiality obligations, if she has any, stem from the non-disclosure provisions of the agreement, not from the arbitration clause.

In the event of a breach of the non-disclosure provisions, the agreement allows either party to obtain an injunction forbidding further disclosure without notice (!!) to the party alleged to have made the disclosure.

It has been reported that Cohen recently obtained such an injunction from an arbitrator in a proceeding administered by ADRS. And in fact, here is a copy of what appears to be the arbitrator’s interim award. (I must say, this is not exactly a high water mark in the history of arbitration…)

Daniels’s complaint alleges that, because Donald Trump did not sign the agreement, she has no contract with him. She also alleges that any contract is unconscionable and/or void as against public policy. Some of these arguments target the confidentiality provisions. There are indeed potent arguments against enforcement of non-disclosure agreements in such cases. However, there is a problem with these arguments (from Daniels’s perspective). If Donald Trump is entitled to invoke the benefits of the arbitration clause, then the arguments must be resolved by the arbitrator (in a private hearing). Put differently, Daniels needs to do more than come up with legally sound arguments against enforcement of the contract and its non-disclosure provisions. If she wants to put pressure on Trump, she needs to come up with legally sound arguments that don’t have to be resolved in arbitration.

From “Dennison’s” perspective, by contrast, a well-drafted arbitration agreement will send as much of the dispute as possible to arbitration. There, Dennison can count on a private hearing. And if the arbitrator rules that the non-disclosure portions of the agreement are enforceable, courts will probably enforce that ruling. Here, then, is the link between arbitration and confidentiality. Although arbitration itself imposes no confidentiality obligations, it can help parties who value confidentiality maintain it, at least if they expect arbitrators to enforce non-disclosure agreements.

It’s here that Dennison’s lawyers may have dropped the ball. Courts always decide whether an arbitration agreement exists. Thus, the court hearing Daniels’s lawsuit against Trump should not refer it to arbitration before deciding, at minimum, whether Daniels is a party to an arbitration agreement. Unfortunately for Daniels, that seems to be a pretty easy call. She is clearly a party to an arbitration agreement; it is just that the agreement doesn’t seem to be with Donald Trump.

But here’s where things get complicated. Even if not a party to the agreement, Donald Trump can invoke the benefits of the arbitration clause if the parties intended to let him do so. Based on my quick read, this seems an entirely plausible interpretation (assuming Trump is David Dennison). But Trump hardly wants to litigate his entitlement to invoke the arbitration clause in public court proceedings. In his ideal world, this issue, too, would be resolved in arbitration. So, too, would disputes over the validity of the arbitration agreement itself—for instance, disputes over whether the arbitration agreement is part of an invalid scheme to circumvent public policy, and disputes over whether the arbitration agreement imposes impermissibly high costs on Daniels (as it arguably does).

Arbitration law allows parties to refer such questions to arbitration. Put differently: if Daniels is a party to an arbitration agreement (as she surely is), then that agreement, if properly drafted, can force her to arbitrate virtually every other issue in dispute. To accomplish this, however, the agreement must provide “clear and unmistakable evidence” of the intent to arbitrate issues that would normally be assigned to a judge. A good way to do that is to include language providing that the arbitrator will have exclusive authority to resolve “any disputes over the validity, scope, or enforceability of this arbitration clause.” But you won’t find language like this anywhere in the settlement agreement. At best, “Dennison” can point to language in the rules of the designated arbitration institutions (like Rule 11 of the JAMS Comprehensive Arbitration Rules). But there are good arguments against treating such language as “clear and unmistakable” evidence of the intent to arbitrate challenges to the validity or scope of the arbitration agreement itself. For one thing, these institutional rules are intended to permit, but not necessarily to require, arbitration of such issues. For another, in such a complicated contract—seemingly created largely for the purpose of obfuscation—it’s not clear that incorporation by reference satisfies the “clear and unmistakable” standard.

Bottom line: Ethics aside, this is a sloppily drafted arbitration clause. The court should decide whether Daniels is party to an arbitration agreement. The court should decide whether Trump is entitled to the benefits of that agreement. And the court should decide whether that agreement is enforceable or is an invalid scheme to circumvent public policy--for instance, by obscuring the fact that a party to (or beneficiary of) the agreement is now President of the United States.

For nearly two decades, the fact that many really large chapter 11 cases file in two districts has been a point of controversy. On the one hand, the present system makes some sense from the perspective of debtor’s attorneys, and many DIP lenders, who value the experience and wisdom of the judges in these jurisdictions and the predictability that filing therein brings. On the other hand, for those not at the core of the present system, it reeks of an inside game that is opaque to those on the outside. And it is not clear the judges outside the two districts could not handle a big case; indeed, most could.

Where big chapter 11 cases should file is an issue again, at least among bankruptcy folks, given the possibility that the pending Cornyn-Warren venue bill might pass as part of some bigger piece of legislation, perhaps the pending S. 2155 (whose Title IV is so misguided it certainly warrants a separate post).

I have long been frustrated by the discussion of chapter 11 venue. On the one hand, the present system has developed largely by accident, with little thought for the broader policy implications. On the other, there is certainly some merit in concentrating economically important cases before judges who are well-versed in the issues such cases present. The issue calls for careful study, but, as with most political issues these days, we are instead presented with a binary choice.

I have often contemplated concentrating the biggest chapter 11 cases among a group of bankruptcy judges, trained in complexities of multi-state or even global businesses. A small panel of such judges could be formed in various regions around the country, such that the parties would never have to travel further than to a neighboring state for proceedings. Geographically larger states – i.e., California and Texas – might comprise regions all by themselves.

Such an approach would ensure that cases would capture some of the benefits of the present system, without the drawbacks of having a Seattle-based company file its bankruptcy case on the East Coast. Comments are open, what do readers think about developing a nationwide group of "big case" judges?

Following up on Alan White's post from this morning about the Education Department's draft notice about debt collection laws applicable to student loan debt collectors that prompted a Twitter moment, some more student loan news from the Education Department. Last week, it posted a less Twitter-popular request for information on evaluating undue hardship claims in adversary proceedings seeking discharge of student loan debt. The summary in the request:

"The U.S. Department of Education (Department) seeks to ensure that the congressional mandate to except student loans from bankruptcy discharge except in cases of undue hardship is appropriately implemented while also ensuring that borrowers for whom repayment of their student loans would be an undue hardship are not inadvertently discouraged from filing an adversary proceeding in their bankruptcy case. Accordingly, the Department is requesting public comment on factors to be considered in evaluating undue hardship claims asserted by student loan borrowers in adversary proceedings filed in bankruptcy cases, the weight to be given to such factors, whether the existence of two tests for evaluation of undue hardship claims results in inequities among borrowers seeking undue hardship discharge, and how all of these, and potentially additional, considerations should weigh into whether an undue hardship claim should be conceded by the loan holder."

As if the power to garnish wages without going to court, seize federal income tax refunds and charge 25% collection fees weren't enough, debt collectors have now persuaded the Education Department to free them from state consumer protection laws when they collect defaulted student loans. Bloomberg News reports that a draft US Ed federal register notice announces the Department's new view that federal law preempts state debt collection laws and state enforcement against student loan collectors. This move is a reversal of prior US Ed policy promoting student loan borrower's rights and pledging to "work with federal and state law enforcement agencies and regulators" to that end, as reflected in the 2016 Mitchell memo and the Department's collaboration with the CFPB.

Customer service and consumer protection will now take a back seat to crony profiteering by US Ed contractors. This news item has prompted a twitter moment.

People have been asking for months when investors will accelerate PDVSA and Venezuela bonds that have fallen into default. Rumor has it that some investors have already done so. But there seems to be a consensus that investors aren't in a hurry. U.S. sanctions prohibit a debt restructuring, and few investors are eager for the legal battle that would follow acceleration. But we’re wondering if this view misses something important and unique to the Venezuelan crisis. It seems to us that investors who file suit may be able to negate most of the Republic's and PDVSA's restructuring tools, significantly enhancing leverage when a restructuring finally does occur and making it easier to hold out. So we’re a bit puzzled why some of the more aggressive investors aren’t already rushing to get judgments.

To explain: Almost every restructuring option available to the government and its state oil company involves exploiting modification provisions in the bond contracts. Most Republic bonds have CACs, which let a supermajority of bondholders in a given series modify payment terms for the entire group, leaving no holdouts. For bonds without CACs--i.e., all PDVSA and a small subset of Republic bonds--the exit consent technique has a smaller bondholder majority accept new bonds and vote to modify the old ones in ways that discourage (but do not eliminate) holdouts.

The problem, as we see it, is that contractual modification provisions do not work against investors who hold money judgments. It isn’t that a money judgment extinguishes all contract-based rights. Readers of this blog may remember the “me too” plaintiffs from the Argentine debt drama. These were holdouts, many holding money judgments, who wanted injunctions similar to the one entered in favor of NML. Judge Griesa gave them what they wanted, rejecting Argentina’s argument that their contract rights under the pari passu clause had “merged” into the judgment they had gotten through litigation. (Here’s his opinion, from June 2015.) We disagreed with him on the wisdom of granting the injunction in the first place, but he was probably correct on this question. Some contract rights are plainly intended to persist, even after one party has successfully sued for breach. And a lawsuit based on those rights often involves an entirely different claim than the one that produced the judgment.

But the question here is different: It is whether a party who has lost a breach of contract lawsuit can later reduce the amount of the judgment by modifying the contract. The answer, we think, must be no. To use the Republic’s CACs as an example: those permit a vote to “modify, amend, or supplement the terms of the Notes,” including a vote to “reduce the principal amount,” so long as the relevant voting threshold is reached. But investors holding money judgments are no longer seeking to recover principal under the bonds; they have an independent right to the amount of money specified in the judgment. Even if the CAC (like the pari passu clause) survives a judgment, it doesn't seem to permit a modification of that right. And even if it did, courts have limited power to set aside judgments; a retroactive modification of rights, even if permitted by contract, doesn’t seem to be one of them.

If the sanctions weren't in place, we wouldn't be talking about such questions. Litigation takes time, and a vote modifying the bonds would likely occur before entry of a judgment. Knowing this, prospective holdouts would favor bonds that are hard to modify. But here, the sanctions give holdouts plenty of time, although (presumably) not forever. So we’re wondering why holdouts aren’t being a bit more aggressive at pressing their claims. We’re also wondering whether they really have reason to prefer Republic bonds without CACs, as press reports indicate, and as would be true in a normal debt crisis. Anna has already expressed skepticism that differences among the Republic bonds will matter in a restructuring. This is another reason for skepticism. What good is a CAC if holdouts already have money judgments?

The Supreme Court weighed in today on one of the the most important circuit splits in the bankruptcy world, namely the scope of one of the section 546(e) safe harbors from avoidance actions in bankruptcy. Section 546(e) has two safe harbors, one for "settlement payments" and the other for transfers "made by or to (or for the benefit of) a ... financial institution ... in connection with a securities contract … commodity contract… or forward contract…”. This latter safe harbor had been read (ridiculously) broadly by some of the courts of appeals, as every non-cash transaction has to go through some sort of financial institution. Specifically, imagine a transaction in which funds are moving from A to D, but go through intermediary financial institutions B and C: A-->B-->C-->D. Can D shelter in the fact that the transfer went through financial institutions B and C?

The Supreme Court unanimously said no, and I think they clearly got the right result, although I fear the methodology the court used may ultimately be unhelpful for those who think that fraudulent transfer law has an important role to play in policing the fairness of financial markets and preventing against excessively risky heads-I-win, tails-you-lose gambles.

The Supreme Court's approach in Merit was, unsurprisingly one of uninspired statutory interpretation. I guess that's to be expected when you have a court filled with con law/admin types who aren't really comfortable on the policy issues, but it's a notable contrast to say, W.O. Douglas's bankruptcy opinions (whatever one thinks of them). The Court saw the case as really being decided by the plain language of the statute, but the Court itself was playing games with the statutory language. Consider this language from the opinion:

The transfer that the “the trustee may not avoid” is specified to be “a transfer that is” either a “settlement payment” or made “in connection with a securities contract.” §546(e) (emphasisadded). Not a transfer that involves. Not a transfer that comprises. But a transfer that is a securities transaction covered under §546(e). The provision explicitly equates the transfer that the trustee may otherwise avoid with the transfer that, under the safe harbor, the trustee may not avoid. In other words, to qualify for protection under the securities safe harbor, §546(e) provides that the otherwise avoidable transfer itself be a transfer that meets the safe-harbor criteria.

Notice the legerdemain here: Justice Sotomayor goes from talking about "a transfer that is...made in connection with a securities contract" to talking about "a transfer that is a securities contract." The words "in connection with" just disappeared! Those are key words that mean something like "a transfer that involves," but the Court just read them out of the statute. That's kind of astounding because literally the transaction at issue was a transfer not from A-->D, but from C-->D, and that is a transfer from a financial institution made in connection with a securities contract. In short, I think the plain language approach here just doesn't work unless one disregards whole words from the statute...as the Court did.

A better approach would have been to disregard financial institutions B and C as agents of A or mere conduits. That's the economic reality of the transaction. B and C are only transferring on funds from A to D because they have been engaged by A to do so. They are acting on A's behalf and are not the meaningfully independent actors. When viewed that way, the transaction really is A to D, and then there's no financial institution involved in its own capacity. I wish the Supreme Court had approached the problem that way because the overly literal (although incorrectly applied) reliance on statutory language creates problems elsewhere in fraudulent transfer land.

An agency or conduit approach to the problem would also have mad sense from a policy perspective. The policy argument for the section 546(e) safe harbors has always been that it is necessary to protect financial institutions from the uncertainty of clawback actions, lest there be spillover effects that roil financial markets generally. Even if one buys that policy argument, it is only an argument for protecting B and C, not the end-recipient D. And if it were otherwise, than any competently advised recipient of a fraudulent transfer or preference would just make sure that the payment went through a financial institution (as it always would with a wire transfer or check), such that constructive fraudulent transfer law would have no purchase in securities, commodities or forward contract transactions.

The Merit Management Group decision means that the selling shareholders in an LBO cannot shelter in fact the payment to them went through a financial institution. But it's worth noting what was not addressed in Merit. First, Merit does not prevent the selling shareholders in an LBO from raising the settlement payment safe harbor of section 546(e). I haven't followed the case closely enough to know why that argument isn't at issue also, but it certainly seems like a viable one. Indeed, under the block quoted language above, it would seem pretty clear that the payment to the selling shareholders is a settlement payment.

Second, Merit doesn't address the situation of a financial institution that is the ultimate recipient of a transfer, that is a financial institution that is in the position of D. In particular, consider a bank that provides the financing for an LBO and receives a security interest for that financing, even though the loan proceeds are not going to the target company, at least in any material way (they might be routed through the target company, but it's window dressing). That bank is not acting as a conduit between the ultimate parties in the transfer; it is one of the ultimate parties in the transfer. Yet, the security interest is being transferred to a financial institution in a transaction that is in connection with a securities contract (the LBO). It's hard to see any policy justification for letting a financial institution benefit from a safe harbor in that situation--if you finance an LBO you shouldn't be surprised if there's subsequently fraudulent transfer litigation against you, and it's hardly going to bring down financial markets (the risk might just make lenders insist on more sustainable LBOs).

This issue remains unresolved by Merit, but the opinion's penultimate sentence is worrisome: "Because the parties do not contend that either Valley View or Merit is a “financial institution” or other covered entity, the transfer falls outside of the §546(e) safe harbor." The implication here is that if the ultimate recipient of a transfer is a financial institution, then no matter whether it was a mere conduit or the end recipient it is protected by 546(e). My approach to disregarding financial institutions from 546(e) when they act as mere conduits wouldn't solve this problem; here they're not mere conduits. Given the Supreme Court's plain language approach in Merit, I'm guessing that is how the court would ultimately rule if it ever confronted the issue, and this is what makes me feel that Merit isn't really a win for those who think fraudulent transfer law plays a critical role in ensuring fairness and constraining excessively risky gambles in financial transactions.

Addendum: I don't have a good response to the section 101(22)(A) definition that Jason Kilborn has highlighted.

If you're challenging a Seventh Circuit ruling in a bankruptcy case on appeal to the Supreme Court, especially if (retired) Judge Posner was in the majority, you've got a challenge ahead. The Court's announcement this morning of its judgment in Merit Management Group v. FTI Consulting demonstrates this yet again. Long story short: paying for stock via a bank transfer (rather than a bag of money) is still a transfer from the buyer to the seller, not the buyer's and seller's banks, and therefore not "by or to ... a financial institution." That is, such transfers are not protected by the securities safe harbor provision in section 546(e) and are subject to avoidance as constructive fraudulent conveyances and/or preferences. The seeming silver-bullet arguments to the contrary in this battle of "plain meanings" apparently remained unarticulated and unavailing (see footnote 2 in the Court's opinion, suggesting someone up there might be reading CreditSlips!). Other big winners in addition to the Illinois-based Seventh Circuit are University of Illinois College of Law professors Charles Tabb and Ralph Brubaker, both of whom are cited prominently and approvingly in the opinion. Congratulations, Illinois!

Student loan debt is growing more rapidly than borrower income. The similarity to the trend in home loan debt leading to the subprime mortgage bubble has been widelynoted. Student loan debt in 1990 represented about 30% of a college graduate’s annual earnings; student debt will surpass 100% of a graduate’s annual earnings by 2023. Total student loan debt also reflects more students going to college, which is a good thing, but the per-borrower debt is on an unsustainable path. Unlike the subprime mortgage bubble, the student loan bubble will not explode and drag down the bond market, banks and other financial institutions. This is because 1) a 100% taxpayer bailout is built into the student loan funding system and 2) defaults do not lead to massive losses. Instead, this generation of students will pay a steadily increasing tax on their incomes, putting a permanent drag on home and car buying and economic growth generally. Student loan defaults do not result in home foreclosures and distressed asset sales. They result in wage garnishments, tax refund intercepts and refinancing via consolidation loans, and mounting federal budget outlays. In many cases, borrowers in default repay the original debt, interest at above-market rates, and 25% collection fees. In other words, defaulting student loan borrowers will remain in a sweatbox for most of their working lives. Proposals to cut back on income-driven repayment options will only aggravate the burden, further shifting responsibility for funding education from taxpayers to a generation of students.

Most defaults do not lead to losses because of the robust collection tools Congress has given the U.S. Education Department. Student loan borrowers in default end up paying, sooner or later, through wage garnishments, federal income tax refund seizures, and consolidation loans. Administrative wage garnishment (no court order required) take 15% of a borrower’s after-tax income. Tax refund intercepts take 100% of the most common form of annual savings, year after year. Borrowers who want to avoid these taxes can in some cases get a consolidation loan, capitalizing all unpaid interest and collection fees into a new loan, restarting the payment clock for another 20 to 25 years, perhaps in an income-driven payment plan at 10%, 15% or 20% of their discretionary income.

In recent years however, US Ed.'s recovery rate on defaulted loans has declined from nearly 90% to around 75%. Until 2015 the interest paid by successful borrowers, especially graduate student and parent loans, more than offset losses on defaults and discharges. For the past three budget years, losses from defaults and income-driven repayment discharges are projected to outstrip interest earnings. This means that taxpayers will share somewhat more in funding student loan debt, although Administration budget proposals now seek to reverse that trend by reducing income-driven repayment subsidies.

The only way out of the sweatbox for borrowers are 1) bankruptcy discharges granted based on “undue hardship”, a very tough standard, 2) discharges based on death or permanent disability, and 3) write-offs of balances after 20 or 25 years of income-based repayment, or shorter periods for some public service loan forgiveness programs. These write-off amounts are modest now, but are growing as the bubble grows.

Instead of a 2008-style crisis, the student loan bubble will be a permanent and heavy drag on economic growth. An entire generation of borrowers cannot buy homes or cars, and will have their spending permanently impaired. When a tipping point will be reached, and when that generation of borrowers will take up their pitchforks, is impossible to guess.

This is an important intervention about a massively important topic that comes up over and over again in sovereign restructurings, and will come up in more and more interesting ways in the next few years.

Saudi Arabia's King Salman has approved a new bankruptcy law. {Download Saudi BK final 2-2018} Commentators have heralded this new law as a boost to economic reforms, in particular to the SME sector, but I have some serious doubts about this. A member of the Shura Council, the King's advisory body, is quoted in one report as explaining "[t]he idea is to simplify and institutionalise the process of going out of business so new organisations can come in." That latter part--new businesses coming in--requires individual entrepreneurs, either the one whose business just failed or new ones, to embrace the major risks of starting a new venture. In either event, a crucial aspect of an effective SME insolvency law, and I would argue THE most crucial aspect, is a fresh start for the failed entrepreneur (and a promise of such a fresh start for potential entrepreneurs). This fresh start is promised and delivered most effectively by provision conferring a discharge of unpaid debt. The new Saudi law all but lacks this key provision. Article 125 on the bottom of page 50 is quite clear about this: "The debtor's liability is not discharged ... for remaining debts other than by a special or general release from the creditors." It seems highly unlikely to me that creditors will offer such releases with any frequency. Yes, the new law provides a useful framework for negotiating restructuring plans, and the Kingdom deserves praise and respect for finally adopting such a measure. But the lack of a law- imposed discharge following liquidation when creditors are not willing to agree is not a foundation for a thriving SME recovery (though I understand and respect the reason why the Saudi law lacks an imposed discharge). Most SMEs are not enterprises--they are entrepreneurs; they are people, not businesses. Leaving these people to bear the continuing burden of unpaid debt does not, in my mind, reinvigorate failed entrepreneurship or entice others to join the movement. I'm afraid the effects on the SME sector of this law will be muted at best. I hope I'm wrong.

If you think it's ridiculous that the CDC can't gather data on gun violence, consider the financial regulatory world's equivalent: S.2155, formally known as the Economic Growth, Regulatory Relief, and Consumer Protection Act, but better (and properly) known as the Bank Lobbyist Act. S.2155 is going to facilitate discriminatory lending. Let me say that again. S.2155 is legislation that will facilitate discriminatory lending. This bill functionally exempts 85% of US banks and credit unions from fair lending laws in the mortgage market. Support for this bill should be a real mark of shame for its sponsors.

There's a lot of bad and whacky stuff in S.2155. Just start with its title. Why would anyone would want to throw more lighter fluid on an already supercharged economy? And isn't it practically daring the Fed to raise rates to offset whatever effect the bill has? Likewise, why do US banks possibly need any regulatory relief when they are at record profit levels--for both megabanks and community banks? This ain't an industry that's hurting.

Turning tot he substance, S.2155 gets it wrong time and time again. Since 2010, megabanks (that is banks with over $50 billion in assets) have been subject to "enhanced prudential standards"--that is extra safeguards to make sure that they do not fail. S.2155 raises that the coverage threshold from $50 billion to $250 billion. Exempt institutions include bit players in the economy such as Goldman Sachs. Is it really wise to exempt large institutions from the additional post-crisis regulation? Firms like Countrywide and Washington Mutual were large enough to cause major economic problems, but they would be exempt from additional regulation under S.2155.

The bad policy judgments in S.2155 aren't just limited to megabanks, however. S.2155 also sets up a lot of community bank failures. One of S.2155's moves is to exempt mortgage loans held in portfolio from the Dodd-Frank Act's "ability to repay" requirement on the theory that if banks have to eat their own cooking they'll be smart about it. I've got an S&L crisis that says otherwise. Here's what will happen: a number of community banks are going to start making long-term, fixed-rate mortgage loans in geographically concentrated areas. And then some of those areas are going to have local economic downturns right when interest rates start to rise. The result will be a bunch of rapidly decapitalized community banks that will fail. If they were dry cleaners or sandwich shops, this would just be the market at work--businesses that make bad decisions fail. But when banks fail there are serious collateral consequences. Sometimes those are global economic crises. And sometimes it's much more local pain, such as a rural community that is left without a local bank, or any bank at all. The ability to make portfolio loans without complying with the ability-to-repay requirement isn't going to be a make-or-break matter for any community bank's bottom line, but it is going to set up a bunch of them to fail, which will, of course, then be blamed on other regulation.

But the worst thing in S.2155 is what it would do regarding discriminatory lending. Discriminatory lending is arguably the very worst activity that occurs in finance. It's worse than outright theft because it isn't neutral as among victims. So what would S.2155 do? It would impair the key tool for policing discriminatory lending, the Home Mortgage Disclosure Act. HMDA is a data collection act. It requires mortgage lenders to report certain information about loan applications and loans funded. That data is the central tool for monitoring for discriminatory lending in the housing market, which is the largest consumer finance market by an order of magnitude, and by far the most important consumer finance market in terms of wealth-building.

To illustrate, consider a recent study by the Center for Investigative Reporting that found that in 61 metro areas around the country (that's basically all large metro markets) people of color were significantly more likely to be denied a conventional home purchase loan than their white counterparts, even after controlling for numerous factors. In Philadelphia, for example, a black family was 2.7 times more likely to be denied a mortgage than an equivalent white family. In other words, discriminatory lending is still very much live and well. (Perhaps no surprise given that we've got a President who settled a housing discrimination suit early in his career.)

Yet what does S.2155 do? It exempts depositories and credit unions that make less than 500 loans per year—85% of banks and credit unions—from HMDA reporting altogether. The bill's sponsors cast this as a reduction in regulatory burdens, but in real terms it means a blanket exemption for 85% of banks and credit unions from the Fair Housing Act and Equal Credit Opportunity Act (at least as applied to mortgage lending). That's shocking. Why on earth should fair lending laws only apply to large institutions? Where do you think discriminatory lending is most likely? At small institutions that rely on face-to-face underwriting determinations and the loan officer's "judgment" or large ones that are doing more algorithmic underwriting? It's the face-to-face underwriting that worries me more, not least because the compliance departments at larger lenders are likely self-testing to ensure that their algorithms are not discriminatory. Without HMDA data, it is near impossible to test for, much less prosecute discriminatory lending by an institution. And that's how S.2155 is the equivalent of telling the CDC not to track gun violence. Take away the data and it's hard to regulation.

S.2155 isn't just a get-out-of-jail free card for small institutions that engage in discriminatory lending. It also impairs the overall usability of HMDA data. There will be many counties in which there is no HMDA reporting whatsoever. That makes it more difficult to use HMDA data even to police discriminatory lending at larger institutions. Shame on the sponsors of S.2155 for backing legislation that guts fair lending laws.

As many Credit Slips readers will know, chapter 11 venue reform has been an issue for decades. As corporate filers have flocked to the Southern District of New York and the District of Delaware, the real reason some observers say is that these courts favor corporate managers, dominant secured lenders, bankruptcy attorneys, or a combination of all of them. Regardless of the merits of these claims, it certainly undermines respect for the rule of law when faraway federal courts decide issues affecting local interests. A great example comes from right here in Champaign, Illinois, where local company Hobbico has recently filed chapter 11. The company, a large distributor of radio-control models and other hobby products, has more than $100 million in debt. The company has over 300 employees in the Champaign area who own the company through an employee stock ownership plan. Yet, the company's fortunes are now in the hands of a Delaware bankruptcy court.

A new, bipartisan bill from Senator John Cornyn (R-Tex) and Senator (and former Credit Slips blogger) Elizabeth Warren (D-Mass) would change the bankruptcy venue rules. The Bankruptcy Venue Reform Act (S. 2282) would no longer allow corporations to file in places in their state of incorporation or where their "affiliates" and subsidiaries already have filed. As a practical matter, these current rules allow the largest corporations to file most anywhere in the United States. Under this new bill, corporations would have to file where their principal assets or principal place of business is located. For publicly traded corporations, "principal place of business" would be the corporate headquarters as identified in their most recent SEC filings. By providing a clear place of venue only where the corporation actually conducts most of its business, the bill would end bankruptcy forum shopping.

As I noted at the start, chapter 11 venue reform has been an issue for decades. A search for "venue" on this blog will lead you to many past discussions of chapter 11 venue abuses as well as past attempts at legislative change. Why might this time be different. First, as the years have passed venue abuse has become bolder. Outside of the congressional representatives of the favored judicial districts, all of the senators and representatives should have more reason to support the bill. Second, the bill has started as a bipartisan effort. Third, the Senate now includes one of the leading bankruptcy scholars of her generation who will bring personal expertise on the issue to her colleagues. There is a sense that this may finally be the moment for actual chapter 11 venue reform.

If you agree, I urge you to contact your senators and representatives and ask them to support the Bankruptcy Venue Reform Act (S. 2282). This past Monday, I did a short segment on our local NPR station as part of a series on legal issues from the law faculty at the University of Illinois. Using the Hobbico bankruptcy as a point of departure, I tried to point out that this is yet another of those seemingly endless technical points of law that affects people more than they realize.

The current Consumer Bankruptcy Project (CBP)’s co-investigators (myself, Slipster Bob Lawless, and past Slipsters Katie Porter & Debb Thorne) just posted to SSRN our new article (forthcoming in Notre Dame Law Review), Life in the Sweatbox. “Sweatbox” refers to the financial sweatbox—the time before people file bankruptcy, which is when they often are on the brink of defaulting on their debts and lenders can charge high interest and fees. In the article, we focus on debtors’ descriptions of their time in the sweatbox.

Based on CBP data, we find that people are living longer in the sweatbox before filing bankruptcy than they have in the past. Two-thirds of people who file bankruptcy reported struggling with their debts for two or more years before filing. One-third of people reported struggling for more than five years, double the frequency from the CBP’s survey of people who filed bankruptcy in 2007. For those people who struggle for more than two years before filing—the “long strugglers”—we find that their time in the sweatbox is marked by persistent debt collection calls, the loss of homes and other property, and going without healthcare, food, and utilities. And although long strugglers do not file bankruptcy until long after the benefits outweigh the costs, they still report being ashamed of needing to file.

Beyond finding that people are spending longer in the sweatbox prior to filing and describing the financial and emotional drain of long strugglers’ time in the sweatbox, our results challenge enduring narratives about who files bankruptcy and why. Prevailing narratives about people filing “bankruptcies of convenience” have profound legal effects. They influence the legislative details of the Bankruptcy Code, how bankruptcy judges rule in individual cases, how attorneys interact with their clients, and even consumer credit laws function more generally. Our results suggest that the bankruptcy system, at present, cannot deliver its promised “fresh start” to many of the families that seek its protection.